The dollar’s fate—Is it tied to the yield curve?

A sharp flattening in the U.S. government bond yield curve this week could be a bearish sign for the dollar, currency analysts say.

Yields on five-year Treasurys have shot up since last week's Federal Reserve meeting raised the prospect of interest rates rising sooner rather than later, narrowing the gap with 30-year bond yields to their tightest spread since 2009.

Although a rise in yields at the short-end of the yield curve usually boosts the appeal of the dollar, a fall in yields at the long-end reflects concerns about the economic outlook and this is weighing on the currency, analysts say.

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The dollar hit a one-week low of 101.71 yen on Thursday and is down more than three percent since the start of the year.

"Part of the currency pair's weakness can be attributed to one of biggest stories in the financial market this week which is that the U.S. yield curve is flattening at an alarmingly rapid pace," Kathy Lien, managing director at BK Asset Management, said in a note.

"Typically yield curves flatten when inflation expectations are falling or investors are worried about slower growth but in this case, short-term rates are rising as long-term rates are falling," she added.

On Wednesday, some of the flattening in the yield curve was unwound, with five-year yields falling after a strong auction of five-year Treasury notes.

Lien said that charts show a clear correlation between dollar/yen and the yield curve, suggesting the dollar could head lower against the yen if the yield curve flattens some more.

Comments last week by new Fed chief Janet Yellen suggesting interest rates could start to rise six months after the scaling back of monetary stimulus ends took markets by surprise, sparking a sharp rise in short-dated Treasury yields. Two-year yields for instance rose to about 0.48 percent on Wednesday, their highest level since last September.

"The curve has been flattening and we've seen two-year yields really move up, especially after the Fed last week because of shifting expectations that maybe rates could move higher sooner than expected," Eric Viloria, currency strategist at Wells Fargo Securities, told CNBC.

"The attraction with [long-dated] U.S. Treasuries also has to do with the risk-on, risk-off dynamic and when you have geopolitical tensions in Eastern Europe or concerns about growth because we've had disappointing data in China," he added.

Ray Attrill, co-head of currency strategy at National Australia Bank, said that it was the way in which the U.S. yield curve has flattened that was impacting dollar/yen.

"Since last week, 10-year yields have come down and this is much less positive for the dollar," he said.

"The underlying message in the data is that the economy is still not gaining momentum, so it may be a case that this is reflected at the long-end of the curve," he added.

Data Wednesday showed orders for U.S. durable goods rose 2.2 percent in February from a month earlier after two straight months of falls. But the data also showed a surprise drop in core capital goods, a gauge of planned spending on capital goods.